The two most important objectives of a business entity include maintaining cash flows and sustaining profitability. Indeed there is a strong relationship between cash flow and profitability of a business.
A business with a healthy cash flow position is liquid and has the ability to meet its short term obligations. Thus, a positive cash flow position helps a business in sustaining its operations and eventually generating profits. Further, these profits can be reinvested in the business in order to achieve growth for the firm.
Thus, we can say that a constant positive cash flow position of a business can help in generating higher profits for the business and increased funds for reinvestment.
Many business owners believe that the success of a firm is determined by the amount of profits it generates. Profits are a good indicator to determine the overall efficiency of the business. However, the profitability of the business does not give a true and fair position of the financial position of the firm.
There might be a possibility that a business generates sufficient profits but it goes out of business. Also, it may be the case that despite being profitable, the company is not able to grow, obtain funds or attract investors. Such a situation arises on account of insufficiency of cash in the business. Therefore, in order to run the business successfully, it needs to maintain adequate cash balances and generate profits.
So before we understand cash flow vs profit, let’s first understand the meaning of each of the terms.
What is Cash Flow?
The term cash flow means movement of cash in and out of your business during a specified period of time. It is the difference between the amount of cash available with a business at the beginning of a period and amount available at the end of that period.
The cash inflows come from your business’ operating, investing and financing activities. For instance, cash received from customers, dividend received on investments and interest received on account of loans given are all cash inflows.
While the cash outflows arise from the payments made towards your business’ operating, investing and financing activities. Cost of goods sold, interest and principal payments and purchase of fixed assets are examples of cash outflows.
Thus, the difference between cash inflows and outflows is called the ‘net cash flow’ in the business.
A business has a positive cash flow position when cash receipts exceed cash payments. Such a situation helps the business in meeting its short term obligations such as paying bills, suppliers, wages, interest etc. On the other hand, a business has a negative cash flow position when cash receipts are less than cash payments. Such a situation makes it challenging for a business to pay immediate bills. Hence, it may have to borrow additional money in order to fill the gap or cover the shortfall.
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Why Cash Flow is Important for a Business?
Cash flows are extremely important in maintaining liquidity of a business. A business with a strong cash flow position is able to manage its cash cycle efficiently. Adequate cash flows allow businesses to meet their short term obligations like payment to suppliers etc. Furthermore, the businesses are able to float their operations during the time lag between receiving payments from customers and making payment to suppliers.
However, if a business is not able to maintain adequate cash balance it will not be able to pay for its operating expenses, inventories etc.This means such a business will not be able to sustain its operations and hence would not be able to generate profits in return.
But, firms can still continue to undertake business in the short to medium term despite making losses. This is possible only if such entities resort to actions like delaying payment to creditors or just incurring variable expenditures. But such business can survive for a long period of time without having adequate cash to meet its immediate needs.
Further, the ability of a business to generate cash is also an important element for attracting investments. This is because lenders do not provide funds to cash strapped businesses. Similarly, investors shy away from investing in illiquid businesses since their expected future payoffs are at stake.
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What is Profit?
Profit is the financial gain that a business earns when the amount of revenue realized from business operations exceeds the expenditure to maintain such operations. Such profit belongs to the business owners who may or may not reinvest such a profit into the business.
The term profitability refers to the ability of a business entity to make profits. This indicates the efficiency of a business enterprise to generate profits by making use of the resources at its disposal. Thus, we can say that profitability is a parameter to measure the overall efficiency of the business. So, there are three ways to determine the profitability of a given business entity .These include:
- relating inputs of a business to its output (i.e. relating output as a proportion of input)
- comparing the financial results of a given firm with the other firms in the industry over a specific period of time
- comparing the results of a given firm over different periods of time
The main objective of every business entity is to earn profits. Further, the amount of profits generated by a business determines the efficiency of its operations. Higher the profit, the greater the efficiency of the business unit. And profitability indicates the relationship between profit and all the other elements that can directly influence the profits earned by a business.
Now profit can be divided into two types:
1. Gross Profit
Gross Profit is an item in Trading and P&L Account of your company that is deduced after subtracting the sum of purchases and direct expenses from sales. That is, it is the difference between net sales revenue and cost of sales. It refers to the profit generated as a result of conducting basic operational activities of your business. Where the basic operational activities involve manufacturing, purchasing and selling of goods.
Importance of Gross Profit
When analyzing the profitability and financial performance of an entity, it is important to consider Gross Profit. This is because it demonstrates the efficiency of the business in making use of its labor, raw material and other supplies.
2. Net Profit
Net Profit is a measure of profitability of a company that is usually referred to as ‘the bottom line’ of the income statement. It refers to the profit that remains after deducting all operating expenses, non-operating expenses, taxes and preferred stock dividends of a business from the gross profit.
Importance of Net Profit
Net profit is a better indicator of efficiency of a business as compared to Gross Profit. This is because it takes into consideration COGS and all the obligations other than COGS. These obligations include operating expenses, interest and taxes.
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Relationship Between Cash Flow and Profit
A business entity needs to have adequate cash balances as well as healthy profits in order to attain success.This means that it has to strive hard to maintain cash balances as well earn profits. Generally, the term cash flow is confused with profit. However, both the terms are not the same. This means that profit showcased in the income statement of the business is not the same as the amount of cash that a business has in its hand. There can be a possibility that a business may have a positive balance of profits.
However, the cash balances may be negative. Thus, without optimum cash balance a business entity cannot survive for long. So, proper cash management strategies need to be in place in order to avoid bankruptcy of the business. Furthermore, huge profits earned by a business does not mean that it is liquid. Therefore, proper cash flow analysis generates information that throws light on the business activities and managerial decisions on which the profitability and sustainability of the business depends.
Though business owners believe that earning profits is the primary objective of the business. But, if the business does not have sufficient amount of cash, the growth of the business would decline. And hence, it’s quite challenging for the business to survive for a very long period of time. Therefore, cash flow is extremely important for existence and survival of the business. Furthermore, business generating healthy cash flows will customarily have higher profitability.
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